IT firms may report 7% Q3 growth

Re rise against pound eats into their profits.

No longer the blue-eyed boys of the stock market, Indian information technology (IT) service providers are expected to declare a 6.5-7 per cent sequential growth (as compared to the trailing quarter) for the third quarter ending December 31, 2007. Analysts also expect the bottom-line growth to range anywhere between 6-10 per cent during the same period.

The third quarter is generally the weakest for most IT firms since it has fewer working days. Infosys and Satyam, in particular, witness weak third quarters. In contrast, the third and fourth quarters are the best for TCS and Wipro.

The calming fact is that unlike the previous two quarters (Q1 and Q2), the US dollar was almost stable (around 1.5 per cent appreciation) for the September-December 2007 quarter. The rupee had appreciated by almost 12 per cent in the first two quarters of FY2007, gnawing into the rupee profit margins.

Of concern in Q3, though, is the trend of the rupee appreciating against the British pound by 3.5-4 per cent which could affect the performance of the companies that have increased their exposure in the UK, following the steep rise in the Indian rupee against the US dollar.

Large share
Most IT firms do not give a break-up of their UK revenue which is clubbed with that of Europe.

For instance, till the second quarter ending September 30, 2007, 19.9 per cent of TCS' revenue came from the UK, while 8.4 per cent accrued from continental Europe.

In the case of Infosys revenue from Europe constitutes 27.4 per cent of the total revenue. For Wipro, the figure is 25 per cent (for Europe), while it was 21 per cent for Satyam.

Moreover, mid-caps like HCL Technologies (28.6 per cent from Europe) and Tech Mahindra (with over 75 per cent of its revenue from British Telecom) too are likely to take a hit.

The appreciation of the rupee against the pound is likely to affect IT companies since most of them would not have hedged adequately against the British currency. Every rupee rise shaves off 30-50 basis points off the operating margins.

However, IT firms can exercise the option to bill their clients in Euros too (against which the rupee depreciated around 0.5 per cent) instead of pounds, notes Krupal Maniar, an analyst from ICICI Securities.

Better efficiency
Nevertheless, the EBIDTA (operating profit) margins for IT firms on an average is expected to be higher in Q3 since the IT firms have effected higher billing rates, lowered their selling, general and administration (SG&A) expenses, and managed costs efficiently, notes Harit Shah of Angel Broking.

Analysts will be keenly watching the indications of IT budgets for CY2008.

Estimates indicate that the 2008 IT budgets for large global banks and financial institutions are seeing pressure post the subprime meltdown in the US. Most CIOs are indicating flat-to-slightly-down budgets for 2008 with cuts in discretionary spending projects in the first half of 2008. The outlook for the second half of 2008 is unclear and would depend on US economic growth in the first half of 2008.

Headed lower
While Indian IT companies do not provide a break-up, J P Morgan analysts believe that 35-45 per cent of business comes from discretionary/project-based work. So short-term changes in discretionary budgets can affect growth rates easily by 10-20 per cent, they reason.

Finally, from a stock market perspective, while Indian IT stocks are no longer expensive on valuations, analysts believe that negative news flow this year would keep stocks range-bound in the near-term.

The stock markets are factoring this weakness with Infosys closing 3.4 per cent lower on Monday from its weekend close. Moreover, while most indices were up on the BSE, the IT index closed 2.9 per cent lower than its previous day's close.